Answer-first summary for fast verification
Answer: Since both banks' spreads increased, the CVA on both sides of the contract will be higher.
The correct answer is C. Since both banks' credit spreads have increased, reflecting a higher perceived credit risk for each bank, the Credit Valuation Adjustment (CVA) for both sides of the contract will be higher. The CVA is a measure of the expected loss from counterparty credit risk over the life of a transaction, and it increases as the counterparty's credit risk increases. This means that the market now expects a higher probability of default and/or a higher loss given default from both HIP and ADB, leading to an increase in the CVA for both banks. The DVA (Debt Valuation Adjustment), which is the bank's own credit risk and the benefit it derives from its own potential default, would also increase for both banks due to the increased credit spreads. However, the question specifically asks about the most likely outcome for an identical 3-year swap entered into today, and the correct response pertains to the CVA, not the DVA.
Author: LeetQuiz Editorial Team
Ultimate access to all questions.
In a 3-year interest rate swap agreement initiated earlier in the year between HIP Bank and ADB Banking Corporation, ADB Banking Corporation agreed to pay HIP Bank a fixed interest rate of 5% in exchange for receiving a payment based on the 6-month LIBOR plus a spread. However, after the swap was executed, both HIP Bank and ADB Banking Corporation experienced downgrades in their credit ratings, resulting in an increased credit spread. Specifically, HIP Bank's credit spread rose from 36 basis points to 144 basis points, and ADB Banking Corporation's credit spread increased from 114 basis points to 156 basis points. Assuming the LIBOR curve remains constant, which of the following statements is most likely to be true if the same 3-year interest rate swap were to be initiated today?
A
Since HIP's spread increased more than ADB's spread, HIP's DVA will increase and ADB's DVA will decrease.
B
Since HIP's spread increased more than ADB's spread, HIP's CVA will increase and ADB's CVA will decrease.
C
Since both banks' spreads increased, the CVA on both sides of the contract will be higher.
D
Since both banks' spreads increased, the DvA on both sides of the contract will be lower.
No comments yet.